May 27, 2010

Bonds are too expensive? Maybe yes, but with a cause

There are two ways to reconcile the bond and equity yields. Either corporate bonds are overpriced or equities are cheap. The last two times, equities turned out to be cheap. This time, given the stresses in the money market, it may be that bonds are too expensive.
‘Smell of fear’ pervades huge sell-off

“Many investors got a tap on the shoulder this week which said that volatility limits have been breached, and it is time to sell any risky positions,” says Dean Curnutt, president of Macro Risk Advisors.

“Once again the main blame for the market jitters is being laid at the door of Europe and the ongoing concerns about the potential for further sovereign debt crises,” said David Jones, chief market strategist at IG Index.

But Geoffrey Yu, of UBS, argued that, while wide-scale risk reduction and deleveraging was dominating market action, liquidity in the global financial system remained ample.

“The current turmoil is far less worrying than that of the second half of 2008 and we believe investors have reason to differentiate between markets,” he said.

“You have a lot of people getting wrong-footed, and not willing to keep adding risk,” said Sebastien Galy, currency analyst at BNP Paribas.

There were heavy losses for commodity currencies, notably the Australian and Canadian dollars and the Norwegian krone, with the yen once again benefiting most as investors bet against carry trades.

Those declines came as Commodity prices, as measured by the Reuters-Jeffries CRB index, fell as much as 2 per cent yesterday – marking a 10 per cent drop since the start of this month.

US and German government bonds rose sharply as trading volumes in peripheral eurozone bonds dried up. The 10-year Treasury yield fell 15 basis points to 3.21 per cent, the lowest since November 2009 while German yields tumbled to historic lows. Even UK gilt yields fell sharply.

Further signs of money market stress came as the three-month dollar Libor/OIS spread – a gauge of banks’ reluctance to lend to each other – widened 2bp to 24bp, the highest since mid-August.